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2 ECONOMIC RESEARCH FORUM RESEARCH REPORT SERIES TAX DESIGN IN TURKEY AND OTHER MIDDLE INCOME COUNTRIES: LESSONS FROM THE MIRRLEES REVIEW Laura Abramovsky, Paul Johnson, David Phillips Koç University - TÜSÝAD ECONOMIC RESEARCH FORUM June 2013 (Yayýn No: ERF-RR/13-01) Rumelifeneri Yolu Sarýyer / Ýstanbul Tel: (0212) o Faks: (0212) June 2013 (Yayýn No: TÜSÝAD-T/ /541) Meþrutiyet Caddesi, No: Tepebaþý / Ýstanbul Telefon: (0212) o Faks: (0212)

3 2013, TÜSÝAD 2013, EAF "All rights reserved. No part of this publication shall be processed/adapted, reproduced, circulated, re-sold, rent, lent, represented, performed, recorded, transmitted with cord/cordless or any technical, digital and/or electronic devices without prior written permission from the author(s)/right holder subject to Article 52 of Law No.4110 amended by Law No.5846 for Intellectual and Artistic Works." ISBN: Kapak Tasarýmý: Kamber ERTEM SÝS MATBAACILIK PROM. TANITIM HÝZ. TÝC. LTD. ÞTÝ. Eðitim Mah. Poyraz Sok. No:1 D.14 Kadýköy - ÝSTANBUL Tel: (0216) Faks: (0216)

4 PREFACE Koç University-TÜSÝAD Economic Research Forum (ERF) is a research center formed jointly by Koç University and the Turkish Industrialists' and Businessmen's Association. Established in 2004 as a non-profit and non-partisan organization, the Economic Research Forum focuses on promoting independent and objective analysis on economic growth and discusses the implications of different economic policy options. In today's rapidly changing economic environment, the global economic structure exhibits a rapid transformation. It is crucial to attune with this economic transformation and wisely fill in the gaps emerging from it. The promise of the new economic setting has transformed how agents view economic relations and unlocked a decision-making process to an innovative set of precedence. With the expanding complexity and interdependence and information-rich environment, policy-making for faster economic growth requires new approaches and fine-tuned calibrations based on longitudinal analyses, rather than rough designs. With these ideas in mind, the business and academic community have joined their forces to launch a new forum on economic research in Istanbul. The report titled "TAX DESIGN IN TURKEY AND OTHER MIDDLE INCOME COUNTRIES: LESSONS FROM THE MIRRLEES REVIEW" is prepared by Laura Abramovsky, Paul Johnson, David Phillips, and published as a part of Economic Research Forum Research Report Series. June 2013

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6 ABOUT THE AUTHORS PAUL JOHNSON Paul Johnson is Director of the Institute for Fiscal Studies (IFS). His previous roles have included director of the public services and growth directorate and Chief microeconomist at HM Treasury, deputy head of the UK Government Economic Service and chief economist at the Department for Education and Skills. He was an editor of the Mirrlees Review and has published widely on issues of tax, social security and other areas of public economics. He has served on the council of the Economic and Social Research Council, was a founder council member of the Pensions Policy Institute, and is on the council of the Royal Economic Society. DAVID PHILLIPS David Phillips is a senior research economist at the IFS working in the Direct Tax and Welfare sector and the Centre for the Evaluation of Development Policy. Phillips's work spans the UK and developing economies, and includes both the analysis of public policy and academic research. Key focuses include poverty and inequality, the analysis of tax and benefit reform, and the modelling of consumer demand and labour supply. Recent projects include the design of tax micro-simulation tools and the analysis of reforms in Mexico and El Salvador for the World Bank; an evaluation of the economic effects of the EU VAT system for the European Commission; analysis of Local Government spending in England; and the analysis of inequality, poverty and tax and benefit reform in the UK. He is also a co-author of the Mirrlees Review chapter Labour Supply and Taxes. LAURA ABRAMOVSKY Laura Abramovsky is a research associate at the IFS currently working in the Centre for the Evaluation of Development Policy. Her research considers firms' behaviour, with specific focus on productivity and innovation issues, programme evaluation and more recently fiscal issues in developing countries. Recent projects include the design of tax microsimulation tools and the analysis of fiscal reforms in Mexico and El Salvador for the World Bank; and the empirical analysis of the impact of increasing the use of highskilled workers abroad has on a multinational firm's use of high-skilled workers at home.

7 ALI I. ÞANVER Ali I. Þanver, after founding and managing law and audit firms and holding counsel positions with Deloitte and White & Case, is currently managing his own law firm, Tasman & Sanver in Istanbul, Turkey. He has extensive experience in the tax and corporate structuring of cross-border transactions, and particularly M&As. Dr. Þanver, who is licensed as both a Turkish attorney and CPA (YMM), received his Abitur from Deutsche Schule Istanbul; his LL.B. from University of Istanbul Law School; his MBA from Boston University School of Management, and: his Ph.D. from Boðaziçi (Turkish/American) University (Ph.D. on Business Combinations, 1995). In 2010, he led projects which enabled his firm to become the first Turkish law firm to win the International Tax Review's Turkish Tax Firm of the Year as well as taking the International Financial Law Review's Turkish Law Firm of the Year. In 2011, he has become one of a few Turkish lawyers to qualify for the exclusive list of Tax Controversy Leaders issued by the International Tax Review. ÜNAL ZENGÝNOBUZ Ünal Zenginobuz is Professor of Economics at Boðaziçi University where he is also the Director of the Centre for Economic Design. He is an associate editor of the Journal of Public Economic Theory and the Economics Bulletin. Professor Zenginobuz's research covers the theory of public goods and local public goods, as well as applications in industrial organization related to regulation policy, independent regulatory agencies, and competition policy in Turkey. He has written reports on the reform of the Turkish tax system and completed a number of research projects on citizens' perceptions of taxation in Turkey.

8 CONTENTS Editors' Introduction...9 Executive Summary...13 Tax Design in Turkey and Other Middle Income Countries: Lessons from the Mirrlees Review, Laura Abramovsky, Paul Johnson, and David Phillips...15 Commentary, Ali Þanver...69 Commentary, Ünal Zenginobuz...77 LIST OF TABLES Table 2.1. General government tax revenues and tax structure of selected countries...22

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10 1 B Ö L Ü M EDITORS' INTRODUCTION

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12 The Institute for Fiscal Studies in London, England is longstanding commentator on taxation with credibility in both the academic and policy worlds. In the fall of 2011, the Institute published the findings of the Mirrlees Review. The Mirrlees review brought together a group of international experts to consider the characteristics a good tax system for an open developed economy in the 21st century. The Review also considered the extent to which the current UK tax system matches this ideal, and how the UK tax system might be reformed to more closely approximate that ideal. The Review has been very positively received and generated much discussion about the appropriate design of modern tax systems. In April 2012, the Koç University - TUSIAD Economic Research Forum invited Paul Johnson, the Director of the Institute of Fiscal Studies (IFS), together with two senior researchers at the IFS, David Phillips and Laura Abramovsky, and Orazio Attansio, a Professor at University College London and a fellow of the IFS to reflect on what lessons the Mirrlees Review might offer for middle income countries and for Turkey, in particular. In this volume we present those reflections, along with responses from two Turkish experts, Mr. Ali Þanver of Tasman and Þanver Associates and Ünal Zenginobuz, who is professor of Economics at Boðaziçi University in Istanbul, Turkey. As the authors discuss further below, the Mirrlees Review is comprised of two volumes. The first volume, Dimensions of Tax Design (Mirrlees et al. (2010)), brings together expert evidence across a wide range of aspects of tax reform, and presents new empirical work on labour supply and consumption behaviour in the UK. The second volume, Tax by Design (Mirrlees et al. (2011)), sets out the conclusions of the Review and recommendations for policy reforms. The importance of the Review stems from its ambition "to identify reforms that would make the tax system more efficient, while raising roughly the same amount of revenue and while redistributing resources to roughly the same degree." The Review initially presented a wide set of critiques and recommendations regarding the British tax system, which has received attention in the UK House of Commons* and its lessons have been discussed in a variety of contexts, including reform of the US tax system as well as in relation to recent reviews that have taken place in Australia and New Zealand. However, the lessons of the Review are only recently being discussed in the context of developing or emerging economies. Indeed, the current report being issued by the Koç University-TUSIAD Economic Research Forum presents one of the most recent attempts to examine the lessons of the Review in detail for a prominent middle-income country - Turkey - in light of the institutional * See See Auerbach., A. (2012). "The Mirrlees Review: A U.S. Perspective," The National Tax Journal, June (2012), 65(2). Evans, C. (2012) "Reflections on the Mirrlees Review: An Australasian Perspective" Fiscal Studies (2011), vol. 32 (3), pp

13 and legal issues that it confronts as well as the benefits that might accrue to it from implementing the recommendations of the Review. In what follows, the re-known researchers from the Institute of Fiscal Studies together with two experts from Turkey provide a detailed overview of the lessons of the Review for middle income countries and suggest new areas for academic research and evidence-based policy initiatives for the reform of the Turkish tax and transfer system to help Turkey in meeting the challenges of moving from a middle income country to a high income one. Editors Sumru Altug and Thomas F. Crossley Koç University-TUSIAD Economic Research Forum College of Administrative Sciences and Economics, Koç University 12

14 EXECUTIVE SUMMARY The cost of taxation is inevitably higher than the sums that are raised to fund public spending: there are administrative costs to government and compliance costs to taxpayers, as well as costs resulting from people changing their behaviour (for instance, to minimise the tax they pay). However, the structure of the tax system plays a crucial role in determining the size of these costs, and, hence, the ability of governments' to raise revenues and redistribute effectively. In the fall of 2011, the Institute of Fiscal Studies in London published the findings of the Mirrlees Review. The Mirrlees Review brought together a group of international experts to consider the characteristics a good tax system for an open developed economy in the 21st century. The contributors to this volume set out some basic principles for thinking about the key features of a good tax system and sound tax reforms in middle income countries, drawing on the findings of the Mirrlees Review. The Review's three guiding principles - that a tax system should work together well as a whole to be progressive and neutral across economic activities (except where there are good reasons to deviate from neutrality) - are likely to be even more important in the context of a middle income country, like Turkey, than in the high income countries for which the Review was originally written. In particular, relatively weaker tax administration systems and greater opportunities for tax evasion in the pervasive informal economy mean that it is even more important to avoid complex systems that through poor design and non-neutralities give many opportunities for tax avoidance and evasion. There may be scope for real improvements in the efficiency and operation of tax systems in middle income countries, including Turkey, by: limited the use of exceptions and reduced rates of VAT; reforming direct taxes to improve savings incentives and remove non-neutralities that encourage distortions in the type of income one chooses to receive treated; and moving towards a more sustainable and investment-friendly form of business taxation that works for both small and large enterprises. A paucity of empirical work on the distributional and behavioural effects of taxes in middle income countries mean there is a real need for research before concrete conclusions on how to reform tax systems can be drawn. Key areas for new empirical work include the development of microsimulation models, estimation of taxable income elasticities and analysis of the response of tax evasion and informal economic activity to taxation to be key areas for new empirical work. 13

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16 TAX DESIGN IN TURKEY AND OTHER MIDDLE INCOME COUNTRIES: LESSONS FROM THE MIRRLEES REVIEW 1 LAURA ABRAMOVSKY, PAUL JOHNSON, DAVID PHILLIPS 2 1 The authors would like to thank Ali Sanver and Ünal Zenginobuz for interesting and helpful commentaries on this paper: earlier drafts of this paper have been much improved in response to their initial comments, and their commentaries highlight important issues on law, politics and the Turkish context, which complement our analysis. The authors would also like to thank Stuart Adam, Helen Miller and Thomas Crossley for helpful comments and suggestions. Any remaining errors are the responsibility of the authors alone. Funding is gratefully acknowledged from Koç University, in Turkey, and the ESRC Centre for the Microeconomic Analysis of Public Policy (CPP) for funding (grant number RES ). 2 Institute for Fiscal Studies. Corresponding addresses:

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18 1. INTRODUCTION Many middle income countries face significant challenges in achieving and sustaining a sound fiscal position. As these countries grow and develop, they need to mobilize more revenue to finance expenditure aimed at reducing poverty and inequality and at improving public infrastructure, while at the same time generating sustainable economic growth. This has led several such countries to undertake, or at least attempt, a range of tax, benefit and spending reforms in recent years. 3 The cost of taxation is inevitably higher than the sums that are raised to fund public spending: there are administrative costs to government and compliance costs to taxpayers, as well as costs resulting from people changing behaviour to minimise the tax they pay. However, the structure of the tax system plays a crucial role in determining the size of these costs, and, hence, the ability of governments' to raise revenues. The key challenge in designing the optimal tax system and in determining the direction for reform is to raise sufficient revenues and satisfy one's equity objectives (i.e. redistribute as much or as little as one wants) at the lowest cost in terms of economic efficiency. The importance of getting the structure of the tax system right, and hence, understanding how various taxes impact on businesses and individuals, can only increase when governments try to raise greater revenues. The issues to consider when thinking about the design of good tax systems and tax reforms are many and complex in all countries. However, the interrelated economic, political and institutional characteristics of middle income countries, including weaker tax administration and institutional capacity, lower tax morale, and a larger informal economy (i.e. higher tax evasion), relative to high income ones, mean the challenge may be greater in such countries. A key problem is that, for many issues, there is a lack of consensus in the growing literature on tax design and reform in middle income 3 Examples of middle income countries that introduced sensible reforms in the last decade include El Salvador and Vietnam among others. El Salvador has introduced a range of reforms, including broadening the bases of VAT and income taxes, eliminating subsidies to exports, introducing a new system of excises on tobacco and alcoholic and non-alcoholic drinks. These are thought to have improved efficiency and fairness as well reducing the burden on the tax administration and increasing tax revenues. Vietnam has recently simplified its corporate income tax regime by unifying the rate structure, removing some incentives, and VAT base has been broadened, resulting in increased tax revenues as well. See Abramovsky et al. (2012) and IMF (2011) for further details. 17

19 economies. For example, some experts argue that value added taxes (VAT) should be used to redistribute resources in these countries given that other more efficient and suitable tools, such as the personal income tax, targeted benefits or public spending (in the form of for example education and health services) are not effectively available (see, for example, Bird (2008)). At the same time, other experts support the contrary view (see, for instance, Levy (2008)). While there are disagreements in the literature on tax design for high income economies, different opinions on how to structure taxes in a context of weaker administrative capacity and greater opportunities for evasion, mean even more disagreement for middle income economies. But, as countries improve their capacity to administer more modern tax-benefit systems and tackle high levels of evasion, such constraints become less binding, meaning that moves towards the kinds of systems advocated for advanced economies will become more feasible. In this paper we set out some basic principles for thinking about the key features of a good tax system and sound tax reforms in middle income countries, and the implications for some particular areas of taxation. In doing this, we take as given governments' goals of certain level of revenue and of redistribution of resources to those with high needs or low incomes, and focus on how these objectives can best be delivered. 4 Our main reference is the set of recommendations from the Mirrlees Review (2011). The Mirrlees Review, inspired by the Meade Report (1978), drew on new work and the large body of existing economic theory and empirical evidence to build a case for tax reform for modern open economies in general, and for the UK in particular. Even though middle income countries differ from advanced economies in several key respects and are themselves a highly diverse group, the principles set out in the Mirrlees Review and many of the implications flowing from them, are relevant: many of the challenges in designing an efficient tax design are similar to those faced by countries such as UK, but writ large. 5 The Review was published in two volumes. The first volume, Dimensions of Tax Design (Mirrlees et al. (2010)), brought together expert evidence across a wide range of aspects of tax reform, and includes new empirical work on labour supply and consumption behaviour in the UK. The second volume, Tax by Design (Mirrlees et al. (2011)), set out the conclusions of the Review and recommendations for policy reforms. The main principles guiding these recommendations are that a good tax system will be 4 In other words, we do not discuss what the level of taxation should be or how much redistribution should be undertaken but instead focus on the key principles of designing tax systems that meet these objectives most efficiently. 5 This view is supported by many experts in the area of tax design and reform in middle income and low income countries. See Tanzi (1999), IMF (2010, 2011), Bird (2008), and Keen (2011) among others. 18

20 progressive - in the sense that it redistributes at a minimum efficiency cost -, neutral - in the sense that it avoids arbitrary distortionary tax differentiation across people and forms of economic activity -, and will achieve its objectives when considered as a whole, with different instruments used for different purposes. Indeed, the Review advocates that one should take this latter point further: the tax and benefits (transfers) systems - and even, where possible, spending on public services - and must be considered together at both the design stage and the analysis stage, to have a full appreciation of their equity and efficiency impacts. In order to focus on a manageable set of issues, however, the Review and this paper primarily on the tax system. The rest of the paper is structured as follows. Section 2 compares some high-level descriptive statistics of the tax systems of middle and high income countries and highlights a number of dimensions in which the economic and institutional characteristics differ between these two groups of countries. Section 3 discusses the general principles for a good tax system drawing from the Mirrlees Review. The implications of these principles and the general economic and institutional characteristics of middle income countries for the design of selected areas of tax policy are discussed in section 4. We focus on personal direct taxes, indirect taxes, and corporate income taxes. 6 In section 5, we provide a summary and discuss the type of empirical work we think is needed to inform the debate about sound tax design and reforms in middle income countries. Finally, at the end of this paper, two Turkish experts on taxation provide commentaries: Ünal Zenginobuz from the perspective of an economist, and Ali Sanver from the perspective of a tax lawyer and legal scholar. The commentaries focus, in particular, on how the principles and recommendations set out in this paper relate to the specific issues affecting Turkey, and emphasise the need to consider the legal and political processes and imperatives that impact the design and operation of the tax system. 2. THE TAX STRUCTURE AND CHARACTERISTICS OF MIDDLE INCOME COUNTRIES Middle income countries as defined by the World Bank are a group of 108 highly diverse economies, and are split in 54 lower and 54 upper middle income economies 6 Section 4.1 (direct taxes) covers briefly the tax treatment of savings and wealth. More detailed discussion of these areas and recommendations for other areas of taxation can be found in the Mirrlees Review: Tax by Design (Mirrlees et al (2011)). One area not considered by either this paper or the Mirrlees Review is the taxation of natural resources. This is obviously a highly relevant area for those middle income countries which rely heavily on revenues from natural resources, and a significant literature examining how best to obtain such revenues exists. See, for instance, Daniel, Keen and McPherson (2010) and Boadway and Keen (2009). 19

21 located across all continents. 7 Upper-middle income countries are economies that had a gross national income per capita between nominal US$4,036 and US$12,475 in Lower middle income countries had a gross national income per capita between nominal US$1,026 and US$4,035. Even within each middle income group, there is a high degree of heterogeneity in the way countries design their tax and benefit systems, in their ability to redistribute income, alleviate poverty, and collect revenue and in their spending patterns. Turkey belongs to the group of upper middle income economies, with a nominal gross national income per capita of $10,410, similar to that of Mexico and Brazil The Tax Structure Table 1 shows the revenues accruing to the government (including sub-national levels of government) and the make-up of these revenues in 2010 for a selected set of middle income and high income countries, as well as group medians. Looking at the group medians it can be seen that total revenue, 9 social contributions (payroll taxes at least nominally linked to social security benefits) and tax revenue (columns 2, 3 and 4 respectively) increase as a share of GDP as GDP increases. This is also true for each specific tax, except for taxes on international trade and transactions (column 11). The median tax/gdp ratio was 15.8% of GDP, 19.2% and 26.2% and median social contributions/gdp ratio was 3.0%, 5.5% and 11.4% for lower middle income, upper middle income and higher income economies respectively, in The difference in total revenues is less stark than the difference for taxes and social contributions, reflecting, in part, the significant recourse to (non-tax) revenues from natural resources in certain countries. In terms of the structure of tax revenues, the most salient difference in group medians is that revenues from the personal income tax (column 9) account for a considerably larger share of GDP in high income countries (7.6%) than in lower and upper middle income countries (2.1% and 2.6% respectively) and contribute a larger fraction of overall tax revenues. Revenues from the corporate income tax is a similar proportion of GDP in the three groups, on average, meaning its contribution to tax revenues declines, on average, as one moves up the income league table. On the other hand, taxes on goods and services account for a slightly lower proportion of GDP but a slightly bigger share of total taxes in middle income countries compared to high income countries. 7 The World Bank "Country and Lending Groups" 2011, see last accessed 8 October See "Gross national income per capita 2011, Atlas method and PPP", last accessed 8 October In addition to tax and social contribution revenues, "Total Revenues" includes other revenue from property income and the sales of goods and services produced by state-owned enterprises, including the exploitation of natural resources. 20

22 However, it is also immediately clear that there is notable within-group variation meaning that one must be wary of taking generalisations too far. Take for example, upper middle income countries. South Africa is the country with the lowest nominal gross national income of the four countries displayed in the table, with $6,960 as shown in column 1, and its tax revenue as a share of GDP is the highest at 27.3%, higher than the median of both upper middle and high income economies. Its take from individual income tax is comparable to that of high income economies, and its tax revenues from corporate income tax are particularly high at 5.7%. It has been suggested that colonial history may be associated with tax revenue performance, with, Anglophone countries with British common law traditions seeming to be better able to raise revenues than Francophone ones among Sub-Saharan economies. 10 Turkey, on the other hand, shows a tax take and a tax structure similar to the median of upper middle income countries. If anything, its central government collects a particularly high proportion of its revenues from indirect taxes, especially excises on items such as, gas, energy, alcohol, cell phone services and luxury goods at different rates as well as a special communication tax. For both these countries, the challenge is not necessarily mobilising more revenue, but thinking about how to improve their tax structure and design to maximise efficiency. In terms of trends over the last two decades since 1990, the median tax revenue as a percentage of GDP for lower and upper middle income countries increased from around 14% and 16.5% to around 16.4% and 20.8% in 2007 before the crisis, though both groups experienced a slight decrease in their median tax-takes from 2007 to In terms of the composition of tax revenue, in the period , there has been a marked increase in the median receipts from general taxes on consumption (which include value added taxes (VAT)) as a share of total tax revenues, going from around 30% to almost 50% of total receipts for both lower and upper middle income countries. This reflects the introduction of VAT in an increasing number of countries (VAT receipts as a share of total receipts went from 15% and 19% in 1990 to 35% and 38% in 2010 in lower and upper middle income countries, respectively), and accords with advice and evidence that VAT is an efficient way to raise revenues. Median receipts from corporate income tax have shown a robust increase from 13% and 12% in 1990 to 17% and 15% for lower and upper middle income countries. This reflects, in part, the introduction of base broadening measures; statutory rates have declined somewhat, as in high income countries, likely reflecting increased international tax competition. Median receipts from personal income tax increased from 7% and 10% in 1990 in lower and upper middle income economies to 14% in both groups in Finally, median receipts from international trade have decreased in importance, from around 25% to around 10% over the period , reflecting trade liberalisation and globalisation more generally. Taken together, these seem encouraging trends: middle income countries are increasing their tax take and relying more on consumption taxes and personal income taxes and less on international trade taxes. 10 See Keen (2011). 21

23 Table 2.1. General Government Tax Revenues And Tax Structure Of Selected Countries Notes: Revenue figures refer to the year Estimates of the share of the informal economy refer to 2007, except for Paraguay (2006). "-"means there is no information available. 1/ Total revenue (column 2) includes Social Contributions (3), Taxes (4), Grants (not displayed in the table), and Other Revenue such as revenue from property income, interest, sales of goods and services including natural resources (not displayed in the table). 2/ Social Contributions (3) includes social security and other social contributions, including by employees, employers and self-employed. 3/ Total Tax Revenue (4) includes Tax Revenue from Goods and Services (5), Income Tax Revenue (8), Tax Revenue from International Trade and Transactions (11), Property Tax Revenue (12), Taxes on payroll and workforce (not displayed in the table), and Other taxes (not displayed in the table). 4/ Tax Revenue from Goods and Services (5) includes General sales, turnover or VAT (6), Excises (7) and Other (not displayed in the table). 5/ Tax Revenue from Income (8) includes Individual Income Tax Revenue (9), Corporate Income Tax Revenue (10) and Unallocable (not displayed in the table). 6/ Tax Revenue from International Trade and Transactions (11) includes revenues from customs and other duties, taxes on exports and other related taxes. 7/ Property Tax Revenue (12) includes revenue from taxes on immovable property, net wealth, estate, inheritance and gift, financial and capital transactions. 8/ Table 2 in Schneider et al (2010), estimates for the "shadow" economy. 9/ Group medians, countries included in each column vary according to whether information is available or not in the IMF data. Sources: The World Bank "Country and Lending Groups" classification 2011, International Monetary Fund data compiled from different sources, provided to the authors by IMF, and Schneider, Buehn and Montenegro (2010). See IMF (2010, 2011) for more information about the IMF data. 22

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